Investing in stocks can be an efficient way to build wealth over time. Learning how to invest wisely and with patience over a lifetime can yield returns that far outpace the most modest income. Nearly every member of the Forbes 400 wealthiest Americans made the list in 2019 because they owned a large block of shares in a public or private corporation.
It all starts with understanding how the stock market works, what your investment goals are, and if you can handle a lot or just a little bit of risk.
Stocks are equity investments that represent legal ownership in a company. You become a part-owner of the company when you purchase shares.
Corporations issue stock to raise money, and it comes in two variations: common or preferred. Common stock entitles the stockholder to a proportionate share of a company’s profits or losses, while preferred stock comes with a predetermined dividend payment.
People are generally talking about common stocks when they talk about buying stocks.
Image by Theresa Chiechi © The Balance 2020
You can profit from owning stocks when the share price increases, or from quarterly dividend payments. Investments accumulate over time and can yield a solid return due to compound interest, which allows your interest to begin earning interest.
For example, you might make an initial investment of $1,000 and you plan to add $100 every month for 20 years. You’d end up with $75,457.50 after 20 years, even though you only contributed $25,000 over time, if you see an annual return of 10% interest.
Benjamin Graham is known as the father of value investing, and he’s preached that the real money in investing will have to be made—as most of it has been in the past—not by buying and selling, but from owning and holding securities, receiving interest and dividends, and benefiting from their long-term increase in value.
The stock market works like an auction. Buyers and sellers can be individuals, corporations, or governments. The price of a stock will go down when there are more sellers than buyers. The price will go up when there are more buyers than sellers.
A company’s performance doesn’t directly influence its stock price. Investors’ reactions to the performance decide how a stock price fluctuates. More people will want to own the stock if a company is performing well, consequently driving the price up. The opposite is true when a company under-performs.
A stock’s market capitalization (cap) is the sum of the total shares outstanding multiplied by the share price. For example, a company’s market cap would be $50 million if it has 1 million outstanding shares priced at $50 each.
Market cap has more meaning than the share price because it allows you to evaluate a company in the context of similar-sized companies in its industry. A small-cap company with a capitalization of $500 million shouldn’t be compared to a large-cap company worth $10 billion. Companies are generally grouped by market cap:
- Small-cap: $300 million to $2 billion
- Mid-cap: Between $2 billion and $10 billion
- Large-cap: $10 billion or more
A stock split occurs when a company increases its total shares by dividing up the ones it currently has. This is typically done on a 2-to-1 ratio.
For example, you might own 100 shares of a stock priced at $80 per share. You’d have 200 shares priced at $40 each if there was a stock split. The number of shares changes, but the overall value you own remains the same.
Stock splits occur when prices are increasing in a way that deters and disadvantages smaller investors. They can also keep the trading volume up by creating a larger buying pool.
Expect to experience a stock split at some point if you invest.
A company’s stock price has nothing to do with its value. A $50 stock could be more valuable than an $800 stock because the share price means nothing on its own.
The relationship of price-to-earnings and net assets is what determines if a stock is overvalued or undervalued. Companies can keep prices artificially high by never conducting a stock split, yet not have the underlying foundational support. Make no assumptions based on price alone.
Dividends are quarterly payments that companies send out to their shareholders. Dividend investing refers to portfolios containing stocks that consistently issue dividend payments throughout the years. These stocks produce a reliable passive income stream that can be beneficial in retirement.
You can’t judge a stock by its dividend price alone, however. Sometimes companies will increase dividends as a way to attract investors when the underlying company is in trouble.
Ask yourself why management isn’t reinvesting some of that money in the company for growth if a company is offering high dividends.
Blue-chip stocks—which get their name from poker where the most valuable chip color is blue—are well-known, well-established companies that have a history of paying out consistent dividends regardless of the economic conditions.
Investors like them because they tend to grow dividend rates faster than the rate of inflation. An owner increases income without having to buy another share. Blue-chip stocks aren’t necessarily flashy, but they usually have solid balance sheets and steady returns.
Preferred stocks are very different from the shares of the common stock most investors own. Holders of preferred stock are always the first to receive dividends, and they’ll be the first to get paid in cases of bankruptcy. The stock price doesn’t fluctuate the way common stock does, however, so some gains can be missed on companies with hypergrowth.
Preferred shareholders also get no voting rights in company elections. These stocks are a hybrid of common stock and bonds.
Investment ideas can come from many places. You can turn to companies like Standard & Poor’s (S&P) or other online resources that might tell you about up-and-coming companies if you want guidance from professional research services. You can take a look at your surroundings and see what people are interested in buying if spending your time browsing investment websites doesn’t sound appealing.
Look for trends and for the companies that are in a position to benefit from them. Stroll the aisles of your grocery store with an eye for what’s emerging. Ask your family members what products and services they’re most interested in and why.
You might find opportunities to invest in stocks across a wide range of industries, from technology to health care.
It’s also important to consider diversifying the stocks you invest in. Consider stocks for different companies in different industries, or even a variety of stocks for organizations with different market caps. An even better-diversified portfolio will have other securities in it, too, like bonds, ETFs, or commodities.
You can buy stock directly using a brokerage account or one of the many available investment apps. These platforms give you the option to buy, sell, and store your purchased stocks on your home computer or smartphone. The only differences between them are mostly in fees and available resources.
Both traditional brokerage companies like Fidelity or TD Ameritrade and newer apps like Robinhood or Webull offer zero-commission trades from time to time. That makes it a lot easier to buy stocks without the worry of commissions eating into your returns down the line.
You can also join an investment club if you don’t want to go it alone. Joining one can give you more information at a reasonable cost, but it takes a lot of time to meet with the other club members, all of whom may have various levels of expertise. You might also be required to pool some of your funds into a club account before investing.
Another way to invest in stocks is through your retirement account. Your employer might offer a 401(k) or 403(b) retirement plan as part of your benefits package. These accounts invest your money for retirement, but your investment options are typically limited to the choices provided by your employer and the plan provider.
You can open an IRA on your own with your bank or brokerage company if your employer doesn’t offer a retirement plan.
There are two types of stockbrokers: full-service and discount.
- Full-service brokers tailor recommendations and charge higher fees, service charges, and commissions. Most investors are willing to pay these higher fees because of the research and resources these companies provide.
- The majority of research responsibility falls on the investor with a discount broker. The broker just provides a platform to perform trades and customer support when needed.
Newer investors can benefit from the resources provided by full-service brokers, while frequent traders and experienced investors who perform their own research might lean toward platforms with no commission fees.
A money manager might also be an option. Money managers select and buy the stocks for you, and you pay them a hefty fee—usually a percentage of your total portfolio. This arrangement takes the least amount of time because you can meet with them just once or twice a year if the manager does well.
The U.S. Securities and Exchange Commission offers helpful advice on how to check out your investment professional before allowing them to manage your money and funds.
You might have to put in more time managing your investments if you want low fees. You’ll likely have to pay higher fees if you want to outperform the market, or if you want or need a lot of advice.
Knowing when to sell is just as important as buying stocks. Most investors buy when the stock market is rising and sell when it’s falling, but a wise investor follows a strategy based on their financial needs.
Keep an eye on the major market indices. The three largest U.S. indices are:
Don’t panic if they enter a correction or a crash. These events don’t tend to last very long, and history has shown that the market will climb again. Losing money is never fun, but it’s smart to weather the storm of a down market and hold onto your investments because they may rise again.
Learning how to invest in stocks might take a little time, but you’ll be on your way to building your wealth when you get the hang of it. Read various investment websites, test out different brokers and stock-trading apps, and diversify your portfolio to hedge against risk. Keep your risk tolerance and financial goals in mind, and you’ll be able to call yourself a shareholder before you know it.